Concept Release: Performance Data and Disclosure for Commodity Trading Advisors and Commodity Pools
Federal RegisterJun 18, 1998
Ask Donna
What actually matters in this document.
Text
COMMODITY FUTURES TRADING COMMISSION
17 CFR Chapter I
Concept Release: Performance Data and Disclosure for Commodity
Trading Advisors and Commodity Pools
AGENCY: Commodity Futures Trading Commission.
ACTION: Request for Comments.
-----------------------------------------------------------------------
SUMMARY: The Commodity Futures Trading Commission (``CFTC'' or
``Commission'') wishes to obtain public comment regarding possible
changes to regulatory requirements which apply to the programs offered
to the public by commodity trading advisors (``CTAs'') and commodity
pool operators (``CPOs''). The proposals discussed in this release
originate from two sources. First, National Futures Association
(``NFA'') submitted a set of proposals (the ``NFA Proposal'') to the
Commission for its approval, which concern computational and disclosure
matters relating to participating in CTA programs on a partially-funded
basis. Second, the Commission staff's preliminary review of the NFA
Proposal gave rise to a number of additional related proposals which
the Commission also wishes to consider. The NFA Proposal is set forth
separately in a section entitled ``NFA Proposal,'' in the form in which
it was submitted to the Commission for approval. NFA's and the
Commission staff's related proposals, collectively, fall within the
following categories: (1) improving risk profile data for clients
considering participation in CTA programs on a partially-funded basis,
(2) providing CTA client account information to FCMs for risk
management purposes, (3) improving risk profile data on commodity
pools, (4) providing a theoretically sound basis of computation and
presentation for rate of return (``ROR'') and related risk profile
data, (5) improving the presentation of historical performance and risk
profile data, and (6) providing periodic statements of program activity
and results to CTA clients.
All of the proposals, including the NFA Proposal and the additional
proposals originated by the Commission staff, are discussed in detail
in Part IV of this release, entitled ``Request for Comment.'' At the
end of each section, questions are posed to help focus public comment
on the issues raised. Comment would also be welcome on any related
issue and need not be limited to the questions posed in this release.
After considering the comments received, the Commission may approve
or disapprove the NFA Proposal without further public notice, may
request NFA to amend its proposal, or may propose for public comment
changes to various Commission rules, advisories or interpretations
pertaining to performance reporting and disclosure.
DATE: Comments must be received on or before August 17, 1998.
ADDRESS: Interested parties should submit their comments to Jean A.
Webb, Secretary of the Commission, Commodity Futures Trading
Commission, Three Lafayette Centre, 1155 21st Street, N.W., Washington,
D.C. 20581. Reference should be made to ``Performance Data and
Disclosure for Commodity Trading Advisors and Commodity Pools.'' In
addition, comments may be sent by facsimile transmission to (202) 418-
5221 or by electronic mail to [email protected].
FOR FURTHER INFORMATION CONTACT:
Paul H. Bjarnason, Jr., Chief Accountant, (202) 418-5459, electronic
mail: ``[email protected];'' Robert B. Wasserman, Special Counsel, (202)
418-5092, electronic mail: ``[email protected];'' Kevin P. Walek,
Branch Chief, (202) 418-5463, electronic mail: ``[email protected];'' or
Eileen R. Chotiner, Futures Trading Specialist, (202) 418-5467,
electronic mail: ``[email protected],'' Division of Trading and
Markets, Commodity Futures Trading Commission, 1155 21st Street, N.W.,
Washington, D.C. 20581.
SUPPLEMENTARY INFORMATION:
I. Background
Past performance information presented to clients and prospective
clients is a primary marketing tool for CTA programs and commodity
pools. This type of information appears in disclosure documents,
advertisements, promotional materials, and in compendia prepared by
third-party services. Performance information is also reported either
directly to clients to communicate the results of the CTA's trading on
behalf of their accounts or in periodic report to investors in public
and private commodity pools.
The Commission's aim is that information provided to clients be
accurate, complete, and understandable. The Commission believes that
performance data can be useful to clients as a way of making risk and
return comparisons among investment alternatives. Performance
information can assist clients in distinguishing one CTA from another
in terms of historical willingness to undertake risk, fee load,
volatility and longer term results or facilitating comparisons with
other investment opportunities. However, the Commission recognizes that
requiring more data does not always result in better information for
clients. It does not wish to overload clients with excessive amounts of
data, nor does it wish to burden CTAs and CPOs with excessive
requirements. As noted above, the Commission and NFA have identified
ways to improve existing regulatory requirements that apply to CTAs and
CPOs. This release discusses a variety of issues and requests public
comment thereon.
II. Discussion
A. Rate-of-Return
The Commission's current requirements for the presentation of ROR
data are based upon the ``return on investment'' (``ROI'') concept used
by economists, financial analysts and other professionals throughout
the business world to measure the results of a variety of investment
activities, from real estate development to internal capital budgeting
to securities or commodities trading. ROI is used to compare various
types of investments, as well as different investment managers.
However, in all areas outside of commodities trading, the divisor used
in the calculation of ROI represents an actual ``investment'' of
tangible assets of the client--that is, the divisors used are amounts
of actual cash funding that are owned or borrowed by the investor.
ROR is calculated, in accordance with Commission regulations, by
dividing the net performance \1\ by the beginning net asset value
(``BNAV'') as of the beginning of the period.\2\ Under current
Commission advisories,\3\ the BNAV used to calculate the ROR must be
based on a set of ``fully-funded'' accounts--accounts for which the
``nominal account size'' \4\ at the inception of the trading program is
equal to the ``actual
[[Page 33298]]
funds'' \5\ subject to the CTA's access and control.\6\
---------------------------------------------------------------------------
\1\ Commission Rules 4.25(a)(7)(i)(D) and 4.35(a)(6)(i)(D)
specify that net performance represents the change in the net asset
value net of additions, withdrawals, redemptions, fees and expenses.
\2\ Commission Rules 4.25(a)(7)(i)(A) and 4.35(a)(6)(i)(A).
Commission Rule 4.10(b) defines ``net asset value'' as ``total
assets minus total liabilities, determined in accord with generally
accepted accounting principles, with each position in a commodity
interest accounted for at fair market value.''
\3\ CFTC Advisory 87-2 [1986-87 Transfer Binder] Comm. Fut. L.
Rep. (CCH) para. 23,624 (June 2, 1987); CFTC Advisory 93-13, 58 FR
8226 (February 12, 1993).
\4\ ``Nominal account size'' is discussed in the next section.
\5\ CFTC Advisory 93-13 defines actual funds as `'the amount of
margin-qualifying assets on deposit in a commodity interest account,
generally cash and marketable securities.''
\6\ A CPO may only report the performance of a pool on the basis
of actual funds. See Advisory 93-13, 58 FR at 8229. However, the
issues discussed herein are applicable to CPOs with respect to
disclosure of CTA performance in pool disclosure documents.
---------------------------------------------------------------------------
``Actual funds'' held pursuant to the CTA's trading program are
funds deposited with the client's FCM either (1) in an account for
which the CTA is granted discretionary trading authority or (2) in
another account, subject to a binding agreement permitting the FCM to
transfer funds to the first account at the direction of the CTA and
committed to the CTA's trading program, as demonstrated by factors
specified in Advisory 87-2.\7\
---------------------------------------------------------------------------
\7\ These factors include the following: (1) the client must
have the same ownership interest in each account; (2) the funds must
be available for transfer to the client's trading account; (3) the
client must commit the funds to the CTA's program under a written
agreement, signed by the FCM, which permits the FCM to transfer up
to a specific amount to the client's regulated commodity account at
the direction of the CTA, and (4) the CTA must be able to
demonstrate that the funds committed to his control were actually
deposited in accounts to which he had access.
---------------------------------------------------------------------------
Commission Rules 4.25 and 4.35 require that the performance of
accounts directed by a CTA be disclosed for the past five years and the
current year to date. In order to permit performance data to be
disclosed without excessive detail and repetition, the rules permit the
performance of all reasonably comparable accounts in each of a CTA's
programs to be shown on a composite basis.\8\ When performance
disclosure requirements were first adopted by the Commission over 20
years ago, the data required under the rules provided only a simple
historical perspective on the profits earned or losses incurred by the
participants in a CTA's or CPO's programs. However, in recent years the
Commission has amplified the requirements to include data which
provides a clearer focus on volatility, as opposed to simply displaying
profits and losses. The performance capsules are now required to
include, among other things, monthly rates of return for the most
recent five calendar years and the current year-to-date, the worst
monthly percentage drawdown \9\ during that time period, the worst
peak-to-valley percentage drawdown \10\ for the time period, and the
amount of funds under management.\11\
---------------------------------------------------------------------------
\8\ Commission Rules 4.25(a)(4) and 4.35(a)(3).
\9\ Commission Rule 4.10(k) defines ``drawdown'' as ``losses
experienced by a pool or account over a specified period.''
\10\ Worst peak-to-valley drawdown is defined in Commission Rule
4.10(l) as ``the greatest cumulative percentage decline in month-end
net asset value due to losses sustained by a pool, account or
trading program during any period in which the initial month-end net
asset value is not equaled or exceeded by a subsequent month-end net
asset value.''
\11\ The table must also include any additional notes needed to
avoid misleading the reader about the CTA's program or the data
presented. Commission Rules 4.24(w) and 4.34(o).
---------------------------------------------------------------------------
B. Nominal Account Size
The ``nominal account size'' is an amount the CTA and the customer
have agreed upon, usually in a written contract.\12\ It determines the
level of trading for the client relative to other accounts in the CTA's
program, regardless of the level of actual funds.\13\ This means that
customers of a given CTA who have the same nominal account size will
have the same trades placed for their accounts. Generally, it also
means that a customer who has agreed to a nominal account size of twice
that of another customer of the same CTA will have twice the number of
positions.\14\ The use of nominal account sizes simplifies management
of the trading for a multiplicity of accounts, especially where the
desired level of trading by the clients is not represented by the
actual funding levels, as explained below.
---------------------------------------------------------------------------
\12\ A written contract would be required under the NFA Proposal
and is required under Advisory 93-13.
\13\ Advisory 93-13.
\14\ In practice, there are exceptions to this rule. For
example, in some programs newly-opened accounts will take up to a
few months to be fully phased into a program. Therefore, an account
being phased in will not always have the full gamut of positions in
it, as compared to the other accounts. Also, in some programs the
smaller accounts may not be large enough to carry the full range of
trades indicated by a CTA's program. In such a case, the CTA may
only include the smaller accounts together with the larger accounts
in the composite and in calculating ROR if it can be demonstrated
that the RORs are materially the same. Advisory 93-13, 58 FR at
8228.
---------------------------------------------------------------------------
It is important to point out what nominal account size does not
represent. It does not represent a particular number of positions,
since there are times when a CTA may believe it prudent to stay out of
the markets entirely or, alternatively, to be more aggressive than
usual. It is not a function of margin requirements, nor is there any
absolute or constant relationship to margin requirements arising from
the CTA's trading. While in a retail context, the nominal account size
is sometimes described as an amount sufficient to make it unlikely that
any further cash deposits will be necessary over the course of the
client's participation in the CTA's program, the client may not look to
the nominal account size as a maximum possible loss, since unexpected
losses could exceed the nominal account size. Therefore, the nominal
account size does not represent the limit of the customer's liability,
nor may any CTA represent that it is an indication of the maximum
likely or possible loss that may be incurred.
Nominal account sizes are not comparable from one CTA to the next.
In discussions with representatives of the industry concerning this
issue over the past ten years, it has become clear to the Commission
staff that there is no method in common use in the industry relating
the nominal account sizes to the number of positions traded. Indeed,
NFA has reported that setting such levels ``is inherently a subjective
process'' and ``a matter of the CTA's judgement.'' \15\
---------------------------------------------------------------------------
\15\ October 2, 1997 letter from Daniel J. Roth, General
Counsel, NFA, to Paul H. Bjarnason, Jr., Chief Accountant, Division
of Trading and Markets, CFTC.
---------------------------------------------------------------------------
Nominal account size is sometimes referred to as a ``legally
binding'' amount. While the amount specified does establish some
legally binding obligations between the customer and the CTA, these
only extend to (1) the basis of the management fees to be paid by the
customer and (2) the trading level to be employed by the CTA for this
account relative to other accounts managed under the same program. the
nominal account size does not represent an obligation to furnish an
amount of actual funds. The account arrangement between the CTA and its
client may be terminated by the client at any time regardless of the
amounts deposited in any account over which the CTA has or had trading
authority. Of course, the client must settle any debits left in the
account at the FCM as a result of trades ordered by the CTA before
termination. As indicated above, these debits could exceed the nominal
account size.
The fact that nominal account size does not represent an actual
investment--or even a comitment--of tangible funds and the lack of a
commonly accepted method for determining the nominal account size have
been major factors in the Commission's reluctance to permit the use of
the nominal account size in determining ROR, except as permitted by
Advisory 93-13.\16\
---------------------------------------------------------------------------
\16\ Advisory 93-13 describes the use of a fully-funded subset
to compute ROR. The fully-funded subset is a device to link the
nominal account sizes assigned by the CTA to its clients to tangible
funding.
---------------------------------------------------------------------------
[[Page 33299]]
C. Evolution of Present Commission Requirements
As mentioned above, the Commission's requirements have evolved over
time in response to identified problems and issues. One of the issues
which has been at the forefront of consideration is the so-called
`'notional funds'' issue. This issue pertains to the determination of
the BNAV, which is the amount to be used as the divisor in the
computation of ROR. The Commission first addressed this issue in 1987.
Consistent with current Commission rules on the matter, Advisory 87-2
affirmed that only actual funds on deposit could be used in determining
BNAV. Its purpose was to permit inclusion in BNAV of funds which are
not carried at the FCM, but which can be reached by the FCM to satisfy
a margin call. Advisory 87-2 provided that actual funds for the ROR
calculation could include funds carried at the FCM or located at other
depositories to which the FCM had access. This Advisory was needed
because a literal application of the Commission's rules resulted in the
exclusion of some funding for accounts which logically should have been
included. For the successful trader, the undue minimization of BNAV had
the effect of resulting in unrealistically magnified RORs. The converse
was true for losses. However, issuing Advisory 87-2 did not solve all
of the reporting issues.
Some clients deposit to the account managed by a CTA actual funds
which are only a fractional percentage of the nominal account size.
This practice is referred to as ``notional funding'' or ``partial
funding.'' As indicated by NFA, the widespread use of partially-funded
accounts raises the issue of how to report the performance of these
accounts in a manner which is not misleading and without creating an
undue number of performance tables. Prior to 1993, the Commission's
reporting scheme was entirely based on ``actual funds.''
Advisory 93-13's main feature was the ``fully-funded subset''
method of ROR reporting. Under this method, the RORs presented in the
performance table were not based upon all the accounts in a CTA's
program. The RORs were based only upon the fully-funded accounts--
hence, the name ``fully-funded subset'' method. The Advisory provided
for a matrix to permit clients to convert the fully-funded subset RORs
to RORs for various partial funding levels. To qualify for the method,
the fully-funded accounts must, in the aggregate, represent at least
ten percent of the total nominal amount of funds traded by the CTA in
the trading program. The Advisory also requires that the CTA make
certain additional calculations to ensure that the subset is
representative of the CTA's program.\17\ As long as the two tests are
met, this method produces approximately the same ROR as does a method
(such as the NFA Proposal) that bases BNAV on the nominal account size.
---------------------------------------------------------------------------
\17\ The latter requirement is not unique to partially-funded
accounts, since all accounts include in a composite must be similar
to one another. The calculation simply established or proved that
the accounts of the fully-funded subset performed similarly to all
of the other accounts.
---------------------------------------------------------------------------
The Commission has also sought to highlight the risk of CTA trading
programs and commodity pools. In August 1995, the Commission enhanced
requirements for the disclosure of the risk of volatility in all CTA
and CPO programs by adding two new disclosure requirements--the largest
percentage monthly drawdown and peak-to-valley drawdown for each
program or pool offered by a CTA or CPO. The Commission felt that this
new dimension to performance data provided a valuable heightened focus
upon the risk of commodities trading, namely the possibility of large
drawdowns of equity--either on a monthly or continuous basis.\18\
---------------------------------------------------------------------------
\18\ While there is generally agreement that past performance
data is not predictive of future performance, academic studies have
shown that it does some predictive value as to volatility. See Scott
H. Irwin, et al., The Predictability of Managed Futures Returns, J.
Derivatives 20, 23 (Winter 1994). This is why the Commission has
sought to emphasize the drawndown aspects of ROR, as opposed to the
profitability aspects.
---------------------------------------------------------------------------
Since August 1995, the Commission has received requests to address
CTAs that have difficulty achieving the fully-funded subset necessary
to qualify to use Advisory 93-13. The interest in this issue suggests
that partially-funded account programs are becoming more prevalent.
Because of the possibility that more clients are participating on a
partially-funded basis, the Commission has become concerned that full-
funded basis data may be irrelevant or misleading for a growing segment
of clients. Since partially-funded accounts are more highly leveraged
than fully-funded accounts, they will incur magnified gains and losses
compared to fully-funded accounts. For example, a customer who is
funding its account at 25% of the nominal account size will realize
gains--and losses--at four times the rate experienced by a fully-funded
client. A loss of 30% on a fully-funded basis will result in a loss of
120% of the investment of a customer which funds its account at 25% of
the nominal level, wiping out the initial investment and leaving a
deficit to be repaid by the customer.
The Commission has also noted that commodity pools are accessing
CTA programs on a partially-funded basis. Therefore, commodity pools
raise similar concerns because their disclosure documents contain
information on the pool's CTAs only on a fully-funded basis.
III. NFA Proposal
On February 26, 1998, NFA submitted for Commission approval a
change to its Compliance Rule 2-29(b)(5) that would require RORs for
CTAs to be based on the nominal account size as described in proposed
NFA Compliance Rule 2-34, rather than upon the actual funds which are
associated with the CTA's program, as presently required by Commission
regulations. Proposed NFA Compliance Rule 2-34 and a related
Interpretive Notice, both of which were previously submitted for
Commission approval, specify certain requirements regarding account
documentation and disclosure for partially-funded accounts, as well as
certain disclosure requirements for COPs.\19\ Together, the amendments
to NFA Compliance Rule 2-29(b)(5), proposed NFA Compliance Rule 2-34,
and the proposed Interpretive Notice constitute the NFA Proposal.\20\
---------------------------------------------------------------------------
\19\ The full text of NFA Compliance Rules 2-29(b)(5) and 2-34
and the Interpretive Notice are attached to this release as Appendix
I.
\20\ The Commission notes that approval of the NFA Proposal by
the Commission would, in order to avoid conflicts between NFA and
Commission rules, require the Commission to rescind its Advisories
87-2 and 93-13, which are discussed elsewhere in this release.
---------------------------------------------------------------------------
The NFA Proposal requires a CTA who directs a client's account to
enter into a written agreement with the client that includes:
(1) The account size which the CTA will use as the basis for its
trading decisions, i.e., the nominal account size;
(2) The name or description of the trading program in which the
client is participating;
(3) Whether the client will deposit, maintain or make accessible
the FCM an amount equal to or less than the nominal account size; and
(4) How additions, withdrawals, profit and losses will affect the
nominal account size and the computation of fees.
The CTA would be required to provide a copy of this agreement to
the FCM carrying the client's account. The CTA would be required to
disclose, in writing, the factors considered by the CTA in determining
any minimum account size of the trading program in
[[Page 33300]]
which the client is participating. In addition, unless a client is a
qualified eligible client as defined in Commission Rule 4.7,\21\ the
CTA would be required to disclose the following information in writing:
---------------------------------------------------------------------------
\21\ Commission Rule 4.7 provides an exemption from certain Part
4 requirements with respect to the operators of commodity pools
whose participants are limited to qualified eligible participants
(``QEPs'') and with respect to commodity trading advisors whose
clients are qualified eligible clients (``QECs''), as those term are
defined by the Rule.
---------------------------------------------------------------------------
(1) An estimated range of the amount of customer equity generally
devoted to margin requirements or option premiums, expressed as a
percentage of the nominal account size, and an explanation of the
effect of partially funding an account at that percentage;
(2) A description of how management fees will be computed,
expressed as a percentage of the nominal account size, and an
explanation of the effect of partially funding an account at that
percentage;
(3) An estimated range of the commissions generally charged to an
account, expressed as a percentage of the nominal account size, and an
explanation of the effect of partially funding an account at that
percentage; and
(4) A statement that the greater the disparity between the nominal
account size and the amount deposited, maintained with or made
available to the FCM, the greater the likelihood, and possible size, of
margin calls.
The NFA Proposal prohibits the use of ROR figures in promotional
material unless such figures are calculated in a manner consistent with
that required under CFTC regulations and are based on the nominal
account size as described in NFA Compliance Rule 2-34.\22\
---------------------------------------------------------------------------
\22\ The NFA Proposal would appear to prohibit the presentation
of ROR figures based on any of the ``actual funds'' methods required
in Commission regulations or permitted in Advisories 87-2 and 93-13.
This language would also appear to prohibit the presentation of
worst month and worst peak-to-valley figures--which are rate-of-
return figures--on a partially-funded basis to prospective
investors. As discussed below, the Commission is requesting comment
on a proposal that CTAs who permit the use of partial funding levels
present such ``worst-case'' information to potential investors on a
partially-funded, ``as-if'' basis, in order to highlight the
increased risk imposed by the leveraging that partial funding
represents. The NFA Proposal would thus proscribe the disclosure of
risks which the Commission proposal would require.
---------------------------------------------------------------------------
The NFA Proposal also imposes disclosure requirements on CPOs who
allocate assets among the pool's CTAs in such a way that the total
allocations to its CTAs are greater than the total assets of the pool.
In particular, the CPO must disclose the following information in
writing to all participants except QEPs, as defined in Commission Rule
4.7:
(1) A statement of the total amount allocated to CTAs as a
percentage of the pool's net assets;
(2) A description of how management fees charged by the CPO and the
CTAs will be computed, including a statement of the total amount of
management fees charged to the pool as a percentage of the pool's net
assets;
(3) An estimated range of the amount of commissions and transaction
fees that will be charged to the pool in the next twelve months and an
estimate of these fees as a percentage of the pool's net assets; and
(4) A statement that allocating in excess of the pool's net assets
among CTAs has the effect of proportionately magnifying the profits and
losses that may be incurred by the pool.
NFA presents several reasons for its Proposal. NFA states that
basing BNAV solely on the amount deposited by the client with the FCM
can distort the past performance results reported to clients. The
accounts of two clients who have permitted the CTA to base its trade
orders on the same account size during the same time period, using the
same program, can show very different RORs based solely on their cash
management strategies. According to NFA, this factor has nothing to do
with the CTA's trading decisions. NFA believes that a CTA's performance
history should reflect the results of the CTA's trading decisions and
should not be affected by the client's cash management strategies. NFA
further believes that computing ROR for partially-funded accounts based
on actual funds on deposit overstates both positive and negative
returns in those accounts. In addition, NFA believes that the fully-
funded subset is so restrictive that more and more CTAs have been
unable to use it.
NFA also recognizes that there are valid concerns regarding the
documentation, disclosure, and sales practice problems that notional
funding can create. According to NFA, however, these concerns are not
computational issues to be addressed through BNAV but are separate
issues that should be addressed independently of the ROR calculation.
Therefore, NFA has proposed using the nominal account size for
calculating BNAV and imposing the separate requirements, which are set
forth above, to address these compliance concerns.
IV. Request for Comment
The Commission shares NFA's concern for accurate disclosure. In
this connection, the proposals, collectively, are designed to ease the
calculation of ROR for CTAs and enhance the amount and quality of data
available to prospective clients of CTAs and investors in commodity
pools. In considering the issues involved, the Commission wishes to
obtain as much information as possible and to consider all relevant
options. The sections below contain discussion and pose questions
regarding several broad topic areas. The Commission does not wish to
limit comment to the issues and questions set forth below, and comment
is welcome on any aspect of CTA or commodity pool ROR reporting,
accounting or disclosure.
A. Disclosure of Risk Profile Data on CTA Programs for Clients
Considering Participation on a Partially-Funded Basis
The Commission staff suggests consideration of expanded disclosure
of historical percentage drawdown data, as explained below.
Discussion: Presently, drawdown data is required to be presented
for CTA programs only on a fully-funded basis. The Commission staff has
become concerned that historical drawdown data presented only on a
fully-funded basis may mislead investors who are considering a
partially-funded participation. It is important to convey to investors,
as clearly as possible, that partially-funded participation in a CTA
program will result in proportionately greater volatility--and
proportionately greater drawdowns--compared to a fully-funded
participation. Accordingly, the Commission wishes to explore the costs
and benefits of requiring drawdown percentage data to be presented at
two or three partial-funding levels that are representative of those
offered by the CTA (e.g., at the 25% 50%, and 75% levels) in addition
to the fully-funded level. Presenting actual drawdown data on a
partially-funded basis would illustrate the volatility of partial
funding with a clarity that could not be achieved in a textual
discussion. A CTA would not be required to present information for
partial funding levels which are below the minimum offered by that CTA
(e.g., a CTA which does not accept accounts which are funded at less
than 50% partial funding would not be required to present information
at the 25% level).
Questions:
(1) What would be the costs and benefits of presenting drawdown
figures geared to two or three partial funding levels?
(2) What would be the most effective format for the presentation?
[[Page 33301]]
B. Presentation of Data Concerning Estimated Margin Ratios
NFA proposes to require CTAs to disclose, to any client which is
not a QEC under Commission Rule 4.7 and which partially funds a
participation in a CTA's program:
An estimated range of the amount of customer equity generally
devoted to margin requirements or option premiums, expressed as a
percentage of the nominal account size of the accounts traded by the
CTA, and an explanation of the effect of partially funding an
account at that percentage.
Proposed Rule 2-34(b)(1) (emphasis added).
Discussion: This ratio, which is to be presented to partially-
funded customers, is nonetheless a measure of the CTA's program on a
fully-funded basis, since it is based upon the nominal account size. It
appears that use of the ratio is intended to provide a measure or
indicator of the risk of the CTA's program. The addition textual
requirement is designed to help clients understand how partial funding
increases such risk.
The Commission believes any new required disclosure should be
assessed in light of its clarity, reliability in achieving its intended
purpose, and its potential for being misunderstood by investors. If
this proposed disclosure were required, it is possible that prospective
clients will compare CTAs on the basis of this ratio. This possibility
leads to the following issues for consideration:
In determining whether presentation of the margin ratio
should be required, it is important to consider whether aggregate
margin requirements are a reliable indicator of risk. It is unclear
that any two portfolios with the same aggregate margin requirement are
equal as to their level of risk, regardless of the mix of commodities
represented or the mix of futures, long and short options comprising
the portfolio. The Commission knows of no academic studies on the
matter, and the staff's experience reviewing margin requirements
indicates that there can be significant differences between margin
requirements relative to the level of risk on different contracts. For
example, the margin requirements on stock index futures are generally
more conservative (i.e., higher relative to volatility) than the margin
requirements on energy products.
The NFA Proposal's provision that the ``estimated'' range
be disclosed allows the CTA to exceed the upper limit of the range
presented. The Commission staff is concerned that disclosure of such a
range might create a misleading expectation of limited losses.
It is unclear that a textual explanation of the risk of
partially funding a CTA program participation, added to the currently
required disclosures, is likely to attract the attention of the
potential investor.
Questions:
(1) Will disclosure of information concerning the margin ratio, as
discussed above, be useful to potential investors? Please give details
of how potential investors will use this information.
(2) What evidence, in the form of studies or otherwise, supports
the proposition that margin requirements are a reliable indicator of
the level of risk?
(3) Does a requirement that CTAs disclose an ``estimated'' range of
the amount of customer equity ``generally'' devoted to margin involve a
standard so inherently discretionary that it creates a danger of
presenting information that is misleading to potential investors?
(4) Would a requirement that CTAs commit to an absolute maximum
percentage of customer equity devoted to margin, beyond which no
margin-increasing changes will be made, provide a more useful
disclosure structure? What would be the advantages and disadvantages of
such a structure? How should such a structure be implemented?
(5) Would any other alternative structures present more useful
information? What would be the advantages and disadvantages of such
structures?
C. Providing the CTA/Client Agreement to the FCM
The NFA Proposal calls for the CTA to provide a copy of the CTA/
client agreement to the FCM carrying the customer's account.
Discussion: NFA has indicated that it believes an FCM would find
the nominal account size useful as a general indicator of the amount
and size of trading intended to be undertaken in the account on behalf
of the customer. The FCM could use this information in making a
determination as to whether to accept this client and, if so, under
what credit terms.
Questions:
(1) Do FCMs consider the client's nominal account size useful
information? Do they currently obtain such information? Would the
imposition of a regulatory requirement aid them in doing so?
(2) Would a different method of providing the FCM with information
concerning nominal account sizes be more efficient? What method (if
any) of communication should be required? What should the timing and
the form of this communication be?
D. Presentation of Risk Profile Data on Commodity Pools
The NFA Proposal imposes various disclosure requirements on CPOs
that allocate assets among a pool's CTAs in such a way that the total
allocations to its CTAs are greater than the total assets of the pool.
One of the requirements is for the CPO to provide a statement of the
total amount of nominal account sizes allocated to a pool's CTAs as a
percentage of the pool's net assets. The Commission desires to obtain
comment on an alternative method of presenting a risk profile for a
commodity pool which was developed by its staff.
Discussion: The most readily apparent use for NFA's proposed ratio
would be for prospective clients to compare one commodity pool to
another. On initial consideration, it might seem that the greater the
amount of the nominal account size compared to pool net assets, the
greater the risk of a pool would be. But in this connection there are
some issues that should be explored.
Although nominal account sizes may be useful in the context of an
individual CTA, it does not follow that the ratio would be a consistent
measure for even a single pool over time. As noted above, nominal
account sizes are not comparable across CTAs. Therefore, a ratio based
on the aggregate of nominal account sizes would not lend itself to
making accurate and reliable comparisons between pools. Moreover, the
ratio of one CTA's nominal account size to the others may change over
time. The Commission is interested in reviewing evidence which
contradicts or supports this preliminary conclusion.
The Commission wishes to explore an alternative approach to
enhancing the presentation of risk profile data for pools. This
approach is founded on the precept that the volatility of a pool is a
function of the volatilities of the investment vehicles (i.e., CTA
programs or investee funds) in which it has invested. Therefore, the
Commission wishes to consider requiring the presentation of data
disclosing, on a pro forma basis, the effect of the worst historical
drawdown for each of the vehicles the pool invested in over the course
of the year. Such a presentation requirement might be implemented as
follows:
(1) For each investment vehicle selected, present the worst
monthly and worst peak-to-valley drawdown percentages on a leveraged
basis for:
[[Page 33302]]
(a) the investment vehicle itself, at the pool's leveraged basis
(e.g., if the fully-funded worst drawdown for CTA ``X'' was 10
percent and the pool funds its participation in the program of CTA
``X'' on a 50 percent basis, the worst drawdown would be presented
as 20 percent); and
(b) the investment vehicle's historical pro-forma impact on the
pool, as though the highest percentage of pool assets over the past
year were invested in the investment vehicle for the full historical
period, at the leverage level of the pool (e.g., if CTA ``X'' had
been allocated 25 percent of the pool's net assets, the 20 percent
worst monthly drawdown would be presented as a 5 percent impact (20%
* 25%) upon the pool's net assets).
(2) For major investee funds, data on the investee fund's major
investments would be required on a ``look-through'' basis, if they
qualified as material under the selection criteria discussed below.
(3) Finally, for each investment vehicle, identify the number of
days during the year that the fund was invested in the vehicle and
whether it is currently so invested.
An example of such a presentation follows:
--------------------------------------------------------------------------------------------------------------------------------------------------------
Investment (leveraged) Impact on fund
---------------------------- Highest ---------------------------- Number of
Investment Worst peak- percentage Worst peak- days held
Worst month to-valley of fund Worst month to-valley
--------------------------------------------------------------------------------------------------------------------------------------------------------
CTA X .............................................................. (20%) (Y%) 25% (5%) (Y *25%) 365
--------------------------------------------------------------------------------------------------------------------------------------------------------
The purpose of the selection criteria is to select investment
vehicles for which detailed risk profile data must be provided, i.e.,
those which expose the pool to the risk of material loss. It is also
important to limit the number of vehicles for which information is
presented, to avoid overwhelming the investor with an excessive volume
of data. Finally, the criteria should consider the pool's investments
over the course of a year, rather than on a particular date, to avoid
strategic behavior aimed at ``cleaning up'' the portfolio for a single
measurement day. One example of a selection method would be the
following:
Identify each investment vehicle in which, at any time during
the course of the year, the actual funds invested by the pool
equaled or exceeded five percent of the pool net assets. For each
such investment vehicle, calculate an index which is the product of
(A) the greatest amount invested (by notional value) times (B) the
vehicle's worst monthly drawdown percentage, times (C) the number of
days during the year that the pool was invested in this vehicle.
Present the data described above for the investment vehicles with
the top N index values.
Questions:
(1) What evidence supports or contradicts the proposition that the
ratio between aggregate notional value and total pool net asset value
is a useful measure of the risk level of a commodity pool?
(2) Would presentation of leverage worst drawdown data, as
described above, for a selection of a commodity pool's investment
vehicles provide useful information to potential investors? What would
be the disadvantages of providing such information? What is the most
effective means of presenting such information? Should the results of
the calculations described above be presented, or should different
information be presented?
(3) Are the selection criteria described above useful? Would a
different selection method be more appropriate? For how many investment
vehicles should the data be presented?
(4) When should this table be presented: in disclosure documents?
Sales literature? Pool annual reports?
E. Theoretical Soundness of the Basis of Computation and Presentation
for ROR and Related Risk-Profile Data
The NFA Proposal does not require CTAs to maintain any fully-funded
accounts to validate their nominal account sizes. By contrast, current
practice, as described in Advisory 93-13, requires a fully-funded
subset comprised of fully-funded accounts accounting for ten percent of
the aggregate nominal account sizes, to validate the nominal account
sizes. The Commission wishes to explore the implications of this
change.
Discussion: The Commission has always sought to ensure that the
methodologies it has required or permitted to be used in the various
reporting schemes under its jurisdiction are based upon sound economic
and accounting principles. In this connection, wherever possible, the
Commission adheres to Generally Accepted Accounting Principles
(``GAAP'') in CTA, commodity pool, and FCM financial reporting. The
fully-funded subset method permitted in Advisory 93-13 is consistent
with the Commission's historical approach to standards by requiring
that the nominal account sizes set by the CTA be validated by the
existence of a subset of accounts that are fully-funded with actual
assets, pursuant to GAAP. This explicit linkage to actual funds, in
effect, permitted to RORs to have some basis in traditional financial
and accounting methods. By contrast, the NFA Proposal, which permits
unrestricted use of the subjectively established nominal account size,
lacks such an anchor or reference point.
Question:
(1) Should the fully-funded subset requirement be retained to
validate the nominal account sizes used by the CTA, or should it be
dropped entirely?
(2) Does the fact that many CTAs may have difficulty in obtaining a
fully-funded subset demonstrate a flaw in the regulatory methodology,
or does it demonstrate an unrealistic setting of nominal account sizes?
In other words, if the greatest actual funding level for any of a given
CTA's accounts was 50% (e.g., all $1 million nominal accounts are
funded at $500,000 or less), is it not more accurate to express the
nominal account sizes at 50% of their initial level?
(3) If the fully-funded subset should be dropped, what would be the
theoretical basis for the method of computing ROR, in terms of economic
and financial accounting theory?
(4) How do nominal account sizes used by CTAs generally fit into
the broader world of financial services, so that a potential investor
might fairly compare investments in commodity pools with other
potential investments?
F. Changes in the Presentation of Historical Data
Current regulations require disclosure of approximately five years
of historical ROR data, presented on a monthly basis, and presentation
on a capsule basis of the single worst monthly drawdown and worst peak-
to-valley drawdown during the same period.\23\ The Commission wishes to
consider the costs and benefits of requiring a longer time-frame for
disclosing performance data for CTAs and commodity pools while reducing
the period for which disclosure of monthly data is necessary in the
basic disclosure documents.\24\
[[Page 33303]]
The focus of the disclosure document would be to provide key profile
information. The Commission staff has also suggested that the
Commission consider expanding the number of worst drawdown months
presented, from one to three or possibly six. The overall effect of
this change would be to reduce the number of data items presented in
the disclosure document, while increasing the scope of the information
made available to the investor.
---------------------------------------------------------------------------
\23\ Commission Rule 4.25(a)(1)(F), (G); Rule 4.25(a)(2)(ii).
The time required is ``the most recent five calendar years and year-
to-date.'' Commission Rule 4.25(a)(5).
\24\ The Commission anticipates that monthly data would be made
available by some means to potential investors who wish it, such as
by mail on request or by inclusion on the CTA's website.
---------------------------------------------------------------------------
Discussion: In many markets, extreme market events do not always
occur within a five-year time-frame, which is the limit of the present
requirement. Often the time interval between market events is ten years
or more. Thus, limiting the historical presentation requirements to a
five-year period, as the current regulations do, may permit some CTAs
and commodity pools to omit their greatest drawdowns from their
historical risk profiles.\25\ Requiring data for a longer period will
present a fuller picture to prospective clients.\26\ Such disclosure is
especially important where notional funding is used, given the
magniification of drawdowns inherent in partial funding.
---------------------------------------------------------------------------
\25\ Commission Advisory 96-1 allows, but does not require, CTAs
to present the performance of offered programs, and CPOs to present
the performance of offered pools, since inception provided that such
performance capsules include, among other things, worst monthly and
peak-to-valley drawdown percentages for both the required five-year
and year-to-date period and since inception of trading for the
program or pool. Comm. Fut. L. Rep. (CCH) para. 26,639 (March 6,
1996).
\26\ For example, recent revisions to the Securities and
Exchange Commission's (``SEC'') Form N-1A, which is used by mutual
funds to register their securities and offer their shares, require
that a fund's risk/return summary include a bar chart showing the
fund's annual returns for each of the last 10 calendar years and a
table comparing the fund's average annual returns for the last 1-,
5-, and 10-fiscal years to those of a broad-based securities market
index. In order to assist investors in understanding the variability
of a fund's returns and the risks of investing in the fund, a fund
must also disclose its best and worst returns for a quarter during
the 10-year (or other) period reflected in the bar chart. Securities
& Exchange Commission, Registration Form Used by Open-End Management
Investment Companies, 63 FR 13916, 13947-52 (March 23, 1998).
---------------------------------------------------------------------------
The Commission also seeks to strike a balance between the sometimes
conflicting goals of requiring all data that would be useful and
avoiding the presentation of a volume of data that is cumbersome to
read and analyze or too complex or voluminous to be easily assimilated
by the prospective client. Therefore, the Commission staff has
suggested that the Commission consider reducing the number of years for
which monthly data is required and presenting the balance of the
information on an annual basis or on some other summary basis, as
discussed below.
In connection with consideration of reducing the number of monthly
data items, the Commission staff has suggested that the Commission
consider requiring more detailed information concerning the volatility
of the CTA's program, either by requiring presentation of an expanded
number of worst drawdown months, e.g., the three worst months or the
six worst months, or by requiring presentation of the standard
deviation of the monthly returns. Presently, only disclosure of the
worst single monthly return is required. Given the unreliability of
past performance data as a predictor of future performance and the
relatively greater correlation between past and future volatility,
presentation of data which is more indicative of volatility seems
warranted.
Questions:
(1) What are the costs and benefits of requiring performance data
for a period greater than the past five years? What period should be
required?
(2) How many years of monthly data should be required? What would
be the most effective method of presenting such data? What would be the
most appropriate method of presenting data for earlier periods (e.g.,
annual performance, annual performance plus footnoted standard
deviation of monthly performance, etc.)?
(3) What data should be presented to enable investors to measure
the volatility of returns from a CTA's program or a commodity pool? How
many months of worst drawdown data should be required (e.g., one,
three, six)? What would be the most effective format for the
presentation of this data?
G. Keeping Clients Regularly Informed Regarding CTA Program Status
The Commission seeks to ensure that clients receive timely and
complete information on the status of their participation in CTA
programs.
Discussion: Commission rules do not currently require that CTAs
provide any periodic reports to their clients.\27\ Presently, the only
information the Commission requires to be reported to a client is that
provided to the FCM (e.g. trade confirmations and monthly account
statements provided to the CTA's clients and to the CTA).\28\ However,
this information does not fully inform the customer as to the status of
its participation in the CTA's program. Among the items the customer
may also need are the following: (a) account fees (e.g., the amount of
fees earned/charged during the period, payments received from client on
amounts owed during the period both through charges to the client
account at the FCM and from sources outside the FCM account, and may
balance unpaid by or credit due to the client at end of the period);
(b) information on the basis of incentive fee calculations (including
the amount of unrecovered prior losses carried forward); and (c) the
current nominal account (i.e., amount originally agreed to, changes
during the period and balance at end of period). It also may be useful
to require the monthly statement to contain the management and
incentive fee percentages, even though they are contained in the CTA/
client agreement. This would permit the clients more easily to verify
the amount charged.
---------------------------------------------------------------------------
\27\ However, Commission Rule 4.36(c)(1)(i) specifies that if a
CTA knows or should know that its Disclosure Document is materially
inaccurate or incorporate in any respect, it must distribute
corrected information to its existing clients.
\28\ Commission Rule 1.33.
---------------------------------------------------------------------------
Questions:
(1) Which of the data items discussed above would be valuable for
clients to receive on a regular basis from CTAs? Are there any other
data items which should be required? How often should this information
be reported to clients? Is there a particular format which should be
required?
(2) What would be the costs for CTAs to report this information to
clients on a regular basis?
(3) On balance, what reporting requirements, if any, should be
established?
V. Conclusion
The Commission believes that it is appropriate to examine concerns
regarding ROR computation and other performance issues which are raised
in connection with the proposals made by the Commission staff and NFA.
The Commission hopes to develop a balanced approach to address these
issues that will enable performance data provided to customers to be as
useful and meaningful as possible, while not being excessively
burdensome to CTAs and CPOs. To this end, the Commission requests
public comment on the proposals and the related issues set forth above.
[[Page 33304]]
Issued in Washington, D.C. on June 11, 1998 by the Commission.
Jean A. Webb,
Secretary of the Commission.
Concept Release: Performance Data and Disclosure for Commodity Trading
Advisor and Commodity Pools
Statement of Commissioner John E. Tull, Jr.
I concur in issuing this Concept Release, because I believe
wholeheartedly in the practice that a better informed agency makes
smarter, better decisions in carrying out its regulatory functions. And
as I have consistently maintained, I believe this agency should defer
to the private sector and self-regulatory organizations to the fullest
extent possible in fulfilling our mission to protect the integrity of
the markets and their users.
Therefore, I welcome and endorse this concept release. I am not
entirely convinced that the rule changes discussed may not create more
confusion than they would resolve. At this point I personally believe
that using the notional amount of an account may be the simplest and
most uniform method of disclosing risk and performance data. This,
after all, is the objective of the rules under consideration.
With that in mind, I look forward to reviewing the comments to this
Concept Release.
John E. Tull, Jr.,
June 11, 1998.
Appendix I--Compliance Rules
* * * * *
RULE 2-29. COMMUNICATIONS WITH THE PUBLIC AND PROMOTIONAL MATERIAL
* * * * *
(b) Content of Promotional Material.
No Member or Associate shall use any promotional material which:
* * * * *
(5) includes any specific numerical or statistical information
about the past performance of any actual accounts (including rate of
return) unless such information is and can be demonstrated to NFA to
be representative of the actual performance for the same time period
of all reasonably comparable accounts and, in the case of rate of
return figures, unless such figures are calculated in a manner
consistent with that required under CFTC Rule 4.25(a)(7)(i)(F) and
are based on the nominal account size (as described in Compliance
Rule 2-34).
* * * * *
RULE 2-34. DIRECTED ACCOUNTS AND COMMODITY POOLS
(a) At the time a Member CTA enters into an agreement to direct
a client's account, the Member CFT must obtain a written agreement
signed by the client (or someone legally authorized to act on the
client's behalf) which states:
(1) the account size which the CTA will use as the basis for its
trading decisions, i.e., ``the nominal account size'';
(2) the name or description of the trading program in which the
client is participating;
(3) whether the client will deposit, maintain or make accessible
to the FCM an amount equal to or less than the nominal account size,
i.e., to fully or partially fund the account; and
(4) how additions, withdrawals, profits and losses will affect
the nominal account size and the computation of fees.
The Member CTA must provide a copy of the agreement to the FCM
carrying the account. The Member CTA must also disclose in writing
the factors considered by the CTA in determining any minimum account
size of the trading program in which the client is participating.
(b) Unless the client is a qualified eligible client under CFTC
Rule 4.7, any Member CTA which directs a partially funded account
must provide the following information in writing to the client:
(1) an estimated range of the amount of customer equity
generally devoted to margin requirements or options premiums
expressed as a percentage of the nominal account size and an
explanation of the effect of partially funding an account on that
percentage;
(2) a description of how the management fees will be computed,
expressed as a percentage of the nominal account size and an
explanation of the effect of partially funding an account on that
percentage;
(3) an estimated range of the commissions generally charged to
an account expressed as a percentage of the nominal account size and
an explanation of the effect of partially funding an account on that
percentage;
(4) a statement that the greater the disparity between the
nominal account size and the amount deposited, maintained or made
accessible to the FCM, the greater the likelihood, and possible size
of, margin calls.
(c) Unless the pool participants are qualified eligible
participants under CFTC Rule 4.7, any Member CPO which allocates
assets among the pool's CTAs in such a way that the total
allocations to its CTAs is greater than the total assets of the pool
must provide the following information in writing to the pool
participants:
(1) a statement of the total amount allocated to CTAs as a
percentage of the pool's net assets;
(2) a description of how management fees charged by the CPO and
the CTAs will be computed, including a statement of the total amount
of management fees charged to the pool as a percentage of the pool's
net assets;
(3) an estimated range of the amount of commissions and
transaction fees which will be charged to the pool in the next
twelve months and an estimate of such fees as a percentage of the
pool's net assets; and
(4) a statement that allocating in excess of the pool's net
assets among CTAs has the effect of proportionately magnifying the
profits and losses which may be incurred by the pool.
(d) Each CTA Member which directs accounts and each CPO Member
which allocates assets among CTAs in such a way that the total
committed is greater than the total assets of the pool shall
maintain the records required by this Rule in the form and for the
period of time required by CFTC Rule 1.31.
(e) Each CTA Member which directs accounts and each CPO Member
to which this rule applies allocates assets among CTAs in such a way
that the total allocated is greater than the total assets of the
pool shall establish and enforce adequate procedures to review all
records made pursuant to this Rule and to supervise the activities
of its Associates in complying with this Rule.
* * * * *
INTERPRETIVE NOTICE NFA COMPLIANCE RULE 2-34
The Board of Directors recently passed NFA Compliance Rule 2-34,
Documentation and Disclosure for Partially Funded Accounts. The
Board recognized that certain customers may, for their own
legitimate business purposes, deposit with the FCMs carrying their
accounts less than the amount which they have directed the CTA
trading their account to use as the basis for trading decisions. The
Board sought to ensure that in such situations performance records
accurately reflect trading results, that there is an adequate audit
trail to verify past performance records and that customers receive
adequate disclosures on the implications of partially funded
accounts.
In the Board's view, the solicitation of partially funded
accounts, particularly with less sophisticated customers, raises a
number of compliance issues. Therefore, the Board wishes to make
clear that NFA Compliance Rule 2-34 does not in any way diminish a
Member's responsibilities under other NFA rules, most notably NFA's
sales practice rules, when dealing with a customer who is
considering a partially funded account.
Specifically, the Member must ensure that any solicitation
present a balanced view of the risks and benefits of such an
arrangement and disclose all material information. Furthermore,
under NFA Compliance Rule 2-30, the Member must obtain the specified
information regarding its customer's experience and financial
condition and, in light of that information, must provide the
customer with an adequate description of the risks of his
investment. As the Board stated in its Interpretive Notice of that
rule, for some customers the only adequate disclosure is that
futures trading is simply too risky for that customer. That is
particularly true when retail customers are induced to increase
their leverage further by partially funding a trading account.
Any Member soliciting unsophisticated customers to trade with a
partially funded account will bear the burden of demonstrating that
its solicitation was in compliance with all NFA requirements.
[FR Doc. 98-16075 Filed 6-17-98; 8:45 am]
BILLING CODE 6351-01-M
This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.